Professional Documents
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CHAPTER 10
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Abstract: Since the mid-1970s, hundreds of academic studies have been conducted in
risk perception-oriented research within the social sciences (e.g., nonfinancial areas)
across various branches of learning. The academic foundation pertaining to the psychological aspects of risk perception studies in behavioral finance, accounting, and
economics developed from the earlier works on risky behaviors and hazardous activities. This research on risky and hazardous situations was based on studies performed
at Decision Research (an organization founded in 1976 by Paul Slovic) on risk perception documenting specific behavioral risk characteristics from psychology that can be
applied within a financial and investment decision-making context. A notable theme
within the risk perception literature is how an investor processes information and the
various behavioral finance theories and issues that might influence a persons perception of risk within the judgment process. The different behavioral finance theories and
concepts that influence an individuals perception of risk for different types of financial
services and investment products are heuristics, overconfidence, prospect theory, loss
aversion, representativeness, framing, anchoring, familiarity bias, perceived control,
expert knowledge, affect (feelings), and worry.
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An emerging subject matter within the behavioral finance literature is the notion of perceived risk pertaining
to novice and expert investors. The author provides an
overview of the specific concepts of perceived risk and
perception for the financial scholar since these two issues
are essential for developing a greater understanding and
appreciation for the psychology of risk. The next section discusses the notion of classical decision making as the cornerstone of standard finance which is based on the idea of
rationality in which investors devise judgments (e.g., the
efficient market hypothesis). In contrast, the alternative viewpoint offers behavioral decision theory as the foundation
for behavioral finance in which individuals formulate decisions according to the assumptions of bounded rationality (e.g., prospect theory). The reader is presented with a
discussion on the major behavioral finance themes (that is,
cognitive and emotional factors) that might influence an
investors perception of risk for different types of financial products and investment services. A major purpose of
this chapter was to bring together the main themes within
the risk perception literature that should provide other researchers a strong foundation for conducting research in
this behavioral finance topic area.
Perceived risk (risk perception) is the subjective decision
making process that individuals employ concerning the
assessment of risk and the degree of uncertainty. The term
is most frequently utilized in regards to risky personal
activities and potential dangers such as environmental
issues, health concerns or new technologies. The study
of perceived risk developed from the discovery that
novices and experts repeatedly failed to agree on the
meaning of risk and the degree of riskiness for different
types of technologies and hazards. Perception is the
process by which an individual is in search of preeminent
clarification of sensory information so that he or she can
make a final judgment based on their level of expertise
and past experience.
In the 1970s and 1980s, researchers at Decision Research,
especially Paul Slovic, Baruch Fischhoff, and Sarah Lichtenstein, developed a survey-oriented research approach
for investigating perceived risk that is still prominent
today. In particular, the risk perception literature from
psychology possesses a strong academic and theoretical
foundation for conducting future research endeavors for
behavioral finance experts. Within the social sciences, the
risk perception literature has demonstrated that a considerable number of cognitive and emotional factors influence a persons risk perception for non-financial decisions. The behavioral finance literature reveals many of
these cognitive (mental) and affective (emotional) characteristics can be applied to the judgment process in relating to how an investor perceives risk for various types
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The prevalent technical jargon within the risk perception literature has emphasized the terminology risk, hazard, danger, damage, catastrophic or injury as the basis for
a definition of the overall concept of perceived risk. Risk
perception encompasses both a component of hazard and
risk; the concept appears to entail an overall awareness,
experience or understanding of the hazards or dangers,
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WHAT IS PERCEPTION?
As a general rule, academic studies on risk or investor
perception fail to express a working or introductory definition of the term perception or neglect to address the
issue of perception in any substantive form or discussion,
whereas works by Chiang and Vennkatech (1988), Epstein
and Pava (1994), Epstein and Pava (1995), and Pinegar and
Ravichandran (2003) provide the term perception in the
title and failed to discuss the term or concept again in their
writings. Unfortunately, this is rather misleading to the
reader in regards to the true subject matter of the academic
work. Even though much of the research on perception is
basic knowledge for researchers in the behavioral sciences
and organizational behavior, it has been essentially disregarded or not adopted for application by researchers in
traditional finance. The work of Gooding (1973) on the
subject of investor perception provides the only work in
finance that has provided an extensive discussion of perception in terms of a behavioral perspective. Only a small
number of research papers by economists have addressed
the notion of perception in a substantive manner in works
by Schwartz (1987), Schwartz (1998), and Weber (2004).
The notion of perception or perceived risk implies that
there is a subjective or qualitative component, which is not
acknowledged by most academics from the disciplines of
finance, accounting, and economics. Websters dictionary
has defined perception as the act of perceiving or the ability to perceive; mental grasp of objects, qualities, etc. by
means of the senses; awareness; comprehension. Wade
and Tavris (1996) provided this behavioral meaning of
perception as the process by which the brain organizes
and interprets sensory information (p. 198). Researchers
in the field of organizational behavior have offered these
two viewpoints on perception:
1. The key to understanding perception is to recognize
that it is a unique interpretation of the situation, not
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The academic literature has revealed a wide interpretation among the different branches of psychology
regarding the exact meaning of the concept of perception.
(See Allport [1955], Garner, Hake, and Eriksen [1956],
Hochberg [1964], Morgan and King [1966], Schiffman
[1976], Bartley [1980], Faust [1984], McBurney and
Collings [1984], Cutting [1987], Rock [1990], Rice [1993],
and Rock [1995].) This is a similar predicament in terms
of the different interpretations of risk across various
disciplines. Researchers from the area of finance and
investments should focus on these basic characteristics of
perception:
r An individuals perception is based on their past expe-
r
r
r
r
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Past experience
Mechanisms of
perception
formation
Interpretation
Information
Perception
Selectivity
Closure
Behavior
Perception Formation
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be understood in a different way among a number of decision makers. This process of interpretation relies on a persons past experience and value system. This mechanism
provides a structure for decoding a variety of stimuli since
an individual has an inclination to think or act in a certain
way regarding a specific situation or activity. Lastly, the
closure mechanism in perception formation concerns the
tendency of individuals to have a complete picture of
any specified activity or situation. Therefore, an individual may perceive more than the information appears to
reveal. When a person processes the information, he or
she attaches additional information to whatever appears
suitable in order to close the thought process and make it
significant. Closure and interpretation have a feedback to
selectivity and hence affect the functioning of this mechanism in subsequent information processing (Kast and
Rosenzweig, 1970, p. 218).
Our discussion of perception has provided some important principles on the perceptual process that should
provide an enhanced understanding of the notion of perceived risk throughout this chapter. The discussion has
attempted to demonstrate the complexity of the perceptual decision-making process from a behavioral finance
viewpoint. The awareness of this perceptual process is
connected directly to how investors process information
under the assumptions of behavioral finance such as
bounded rationality, heuristics, cognitive factors, and affective (emotional) issues.
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that do not comply with the strong assumptions of rationality. Therefore, this would demonstrate that individuals
are influenced by some different types of cognitive (mental) processes and/or affective (emotional) factors. These
types of behaviors in tandem with market inefficiencies
could result in the following issues: (1) investor perceptions are influenced by their current risk judgments concerning a certain financial instrument or the overall markets, and (2) individuals failure to discover and determine
the right investment such as selecting a stock or mutual
fund investment.
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According to classical decision theory, the standard finance investor makes judgments within a clearly defined
set of circumstances, knows all possible alternatives and
consequences, and selects the optimum solution. The discipline of standard finance has advanced and flourished
on four basic premises in terms of rational behavior:
1. Investors make rational (optimal) decisions.
2. Investors objectives are entirely financial in nature, in
which they are assumed to maximize wealth.
3. Individuals are unbiased in their expectations regarding the future.
4. Individuals act in their own best (self) interests.
Classical decision theory has often been described as
the basic model of how investors process information
and make final investment decisions. According to Statman (1999), an attractive aspect of the standard finance
perspective is it uses a minimum of tools to build a
unified theory intended to answer all the questions of
finance (p. 19). Thus, by advocating rationality, standard finance researchers have been able to create influential theories such as modern portfolio theory (MPT) and
EMH. At the same time, these researchers have been able
to develop effective risk analysis and investment tools
such as the arbitrage pricing theory (APT), the capital asset pricing model (CAPM), and the Black-Scholes option
pricing model in which investors can value financial securities and provide analysis in an attempt to predict the expected risk and return relationship for specific investment
products. Nevertheless, an extensive debate has ensued
about the validity of rational choice (that is, issues of rationality) between the disciplines of economics and psychology in works by Arrow (1982), Hogarth and Reder (1986),
Antonides (1996), Conlisk (1996), Schwartz (1998), and
Carrillo and Brocas (2004). According to Arrow (1982), the
hypotheses of rationality have been under attack for empirical falsity almost as long as they have been employed
in economics (p. 1).
Psychologists from the branches of cognitive and experimental psychology have made the argument that the
basic assumptions of classical decision theory are incorrect since individuals often act in a less than fully rational manner. According to the assumptions of behavioral
decision making, the behavioral finance investor makes
judgments in relation to a problem that is not clearly
defined, has limited knowledge of possible outcomes
and their consequences, and chooses a satisfactory outcome. The disciplines of behavioral finance and economics
were founded on the principles of bounded rationality by
Simon (1956) in which a person utilizes a modified version
of rational choice that takes into account knowledge limitations, cognitive issues, and emotional factors. Singer and
Singer (1985) described the difference between two sets of
decision makers from this viewpoint, economists seek to
explain the aggregate behavior of markets, psychologists
try to describe and explain actual behavior of individuals
(p. 113). A noteworthy criticism of standard finance was
offered by Skubic and McGoun (2002), for a discipline
having individual choice as one of its fundamental tenets,
finance surprisingly pays little attention to the individual
(p. 478).
Under the tenets of rational behavior, an investor is assumed to possess the skill to predict and consider all pertinent issues in making judgments and to have infinite
computational ability. Rationality suggests that individuals, firms, and markets are able to predict future events
without bias and with full access to relevant information
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The assumption made is that investors utilize conventional investment techniques or financial models that have
an established historical presence.
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The alternative perspective is known as behavioral decision theory (BDT), which has an extensive academic history within the social sciences such as cognitive and
experimental psychology that has provided a more descriptive and realistic model of human behavior. The
basis of this theory is that individuals systematically
infringe upon (violate) the normative tenets of economic (finance) rationality by: (1) miscalculating (underestimating or overestimating) probabilities, and (2)
making choices between different options based on
noneconomic (nonfinancial) factors. (See, for example,
Edwards [1954], Slovic [1972], Slovic, Fischhoff, and
Lichtenstein [1977], Einhorn and Hogarth [1981], Kahneman, Slovic and Tversky [1982], Slovic, Lichtenstein,
and Fischhoff [1988], Weber [1994], Gigerenzer and Goldstein [1996], Mellers, Schwartz, and Cooke [1998], Mullainathan and Thaler [2000], Shefrin [2001a], Warneryd
[2001], Gowda and Fox [2002], Bazerman [2005], Barberis
and Thaler [2005], Coleman [2006], and Taylor-Gooby and
Zinn [2006].)
BDT explains how the human aspects of decision making affect individuals such as the measurement of common systematic errors that result in individual investors
and professional investors departing from rational behavior. In its simplest form, the behavioral decision maker
is influenced by what he or she perceives in a given situation, event, or circumstance. For this discussion, one
of the substantive aspects of BDT is the significant role
of bounded rationality. Bounded rationality proposes that
decision makers are limited by their values and unconscious reflexes, skills, and habits as identified by Simon
(1947, 1956, and 1997). In effect, bounded rationality is
the premise that economic rationality has its limitations,
especially during the judgment process under conditions
of risk and uncertainty. According to Ricciardi (2006), investors would identify more with the tenets of bounded
rationality proposed by behavioral finance instead of the
limited constraints of rationality espoused by standard
finance.
According to behavioral finance decision theory (the
descriptive model), an investor displays cognitive bias,
heuristics (rules of thumb), and affective (emotional) factors that have been disregarded by the assumptions of
rationality under classical finance decision theory (the normative model). Shefrin (2000) clarifies the difference between cognitive and emotional issues, cognitive aspects
concern the way people organize their information, while
the emotional aspects deal with the way people feel as they
register information (p. 29). Olsen (2001) provided the
following perspective of the behavioral finance decisionmaking process:
r Financial decision makers preferences tend to be mul-
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3. Rationality requires a choice among all possible alternative behaviors. In actual behavior, only a very few
of all these possible alternatives ever come to mind.
(Simon, 1947, p. 81)
Furthermore, Simon (1956) rejected rational models of
choice for ignoring situational and personal limitations,
such as time and cognitive ability. In the 1950s, Simon
developed and advanced the notion of bounded rationality that explored the psychological aspects that influence
the economic judgment process. Kaufman, Lewin, Mincer,
and Cummings (1989) provided this portrayal of a more
realistic and practical person from the social sciences:
A textbook description of behavioral man would run
along the following lines: individuals typically do not
maximize, but rather select the first alternative outcome that satisfies their aspiration level, and because
there are severe limits to information and knowledge
of alternative outcomes, people act on the basis of a
simplified, ill-structured mental abstraction of the real
world-an abstraction that is influenced by personal perceptions and past experiences. Although this model of
man is largely foreign to economists, in various guises
it underlies much of the industrial relations-oriented
research done by scholars in personnel, organizational
behavior, and sociology (p. 76).
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The following are criticisms of the behavioral finance perspective or what Hirshleifer coined the objection to psychological approach:
r The so-called behavioral biases (e.g., the role of cognitive
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then, applied to the development of risk communication programs for experts and the general public.
6. The central role of cultural factors among an international research sample for a variety of different
countries.
Ricciardi (2004) offers a comprehensive list of behavioral
risk characteristics (see Table 10.1) that were examined by
risk perception researchers in behavioral finance and accounting within a financial and investment setting. Table
10.1 provides the specific behavioral risk indicators that
were examined by researchers in these two disciplines:
(1) 12 risk behavioral attributes (characteristics) within
behavioral accounting based on 12 research studies for
the time period of 1975 to 2003, and (2) 111 behavioral
risk indicators within behavioral finance for 71 endeavors for the time period of 1969 to 2002. However, below
we will only provide a brief discussion of the prevalent
cognitive issues and affective (emotional) factors of behavioral finance that influence a persons perception of
risk including: heuristics, overconfidence, prospect theory, loss aversion, representativeness, framing, anchoring,
familiarity bias, perceived control, expert knowledge, affect (feelings), and worry.
Heuristics
Kahneman, Slovic, and Tversky (1982) noted that when
individuals are faced with a complex judgment such as
a statistical probability, frequency or incomplete information; various subjects utilize a limited number of heuristics
that reduce the decision to a simpler task. Heuristics are
simple and general rules a person employs to solve a specific category of problems under conditions that involve a
high degree of risk-taking behavior and uncertainty. Myers (1989) provided this viewpoint on heuristics, all of
us have a repertoire of these strategies based on bits of
knowledge we have picked up, rules we have learned, or
hypotheses that worked in the past (p. 286). These strategies known as heuristics in the formal sense are rules
of thumbs that are considered very common in all types
of decision-making situations. Furthermore, heuristics are
a cognitive tool for reducing the time of the decisionmaking process for an individual investor or investment
professional. In essence, heuristics are mental shortcuts
or strategies derived from our past experience that get us
where we need to go quickly, but at the cost of sending
us in the wrong direction (Ricciardi and Simon, 2001, p.
19) or introducing biases that result in over or underestimating the actual outcome. An investor utilizes heuristics
when given a narrow time frame in which he or she has
to assess difficult financial circumstances and investment
choices. Eventually, these mental processes (heuristics) result in the individual making investment errors based
on their intuitive judgments. Plous (1993) wrote:
For example, it is easier to estimate how likely an outcome is by using a heuristic than by tallying every past
occurrence of the outcome and dividing by the total
number of times the outcome could have occurred. In
most cases, rough approximations are sufficient (just as
people often satisfice rather than optimize). (p. 109)
The significance of heuristics in the domain of risktaking behavior and uncertainty has been a major source of
research within the area of judgment and decision making
in works by Tversky and Kahneman (1973), Kahneman,
Slovic, and Tversky (1982), Slovic (2000), and Gilovich,
Griffin, and Kahneman (2002). Two major types of factors
that have an affect on a persons perception of risk are the
availability heuristic and overconfidence as indicated by
Slovic, Fischhoff, and Lichtenstein (1979).
Availability Heuristic
One of the underlying principles of risk perception research has been the availability heuristic based on the
work of Tversky and Kahneman (1973). This heuristic is
utilized in order to judge the likelihood or frequency of
an event or occurrence. In various experiments in psychology, the findings have revealed individuals tend to be
biased by information that is easier to recall, influenced
by information that is vivid, well-publicized, or recent.
An individual that employs the availability heuristic will
be guided to judge the degree of risk of a behavior or hazardous activity as highly probable or frequent if examples
of it are easy to remember or visualize. Furthermore, the
availability heuristic provides the inclination for an individual to form their decisions on information that is easily
available to them. The main issues that have involved the
availability heuristic are (1) activities that induce emotions, (2) tasks that are intensely dramatic, and (3) actions
that have occurred more recently have a propensity to be
more accessible in our recent memory. Schwartz (1998)
described the availability heuristic in this manner:
Biases may arise because the ease which specific instances can be recalled from memory affects judgments
about the relative frequency and importance of data.
This leads to overestimation of the probability of wellpublicized or dramatic events . . . or recent events along
with the underestimation of less recent, publicized or
dramatic events . . . A prominent example of the availability bias is the belief of most people that homicides
(which are highly publicized) are more common than
suicides, but, in fact, the reverse is true. (p. 64)
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Table 10.1 Risk Perception Studies from Behavioral Finance and Accounting:
A Master List of Behavioral Risk Characteristics (Indicators)
Behavioral Accounting: 12 Behavioral Risk Attributes for 12 Research Studies
1. Familiarity factor or issues of familiarity (influence of stock
name vs. withholding name of company)
2. Search for additional information
3. Worry
4. Voluntary
5. Control
6. Chance of a catastrophic outcome
57. Confidence
58. The level of investment
59. Degree of hazard (and gain)
60. Chance of incurring a large loss
61. Economic expectations
62. Financial knowledge index
63. Chance or incurring a large gain
64. Locus of control index
65. Money ethics variable
66. Law of small numbers factor
67. Illusion of control
68. Overconfidence
69. Ability of competitors
70. Possibility of a loss
71. Magnitude of a loss
72. Gathering more information
73. Control over situation
74. Drawing on expertise
75. Consulting with colleagues
76. Sharing responsibility
77. Reputation
78. Seriousness
79. Losses delayed
80. Not known to investors
81. Not known to experts
82. Lose all money
83. Adverse effect on economy
84. Losses unobservable
85. Complex to understand
86. Unacceptable sales pressure
87. Unsound advice
88. Poor investor protection
89. No regulation
90. Unethical
91. Monitoring time
92. Information prior to purchase
93. Ruin
94. Perceived outcome control
95. Gain (favorable position)
96. Loss (unfavorable position)
97. Self-efficacy
98. Knowledge of investment principles
99. Control the possible returns of the decision
100. Control the risks involved in the problem
101. Personal consideration of making the decision
102. Familiarity assets vs. unfamiliarity assets
103. Taking more time to reach a decision
104. Reducing the number of decisions
105. Concern for below-target returns
106. Ruinous loss (potential for large loss)
107. Acquaintances who invest in instrument
108. Divergence of opinion (uncertainty)
109. Inability to estimate total amount of potential loss
110. Perceived personal control (Internal locus of control)
111. Uncertainty measure (lack of information, inability to
assign probabilities with degree of confidence)
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Overconfidence
Overconfidence is another characteristic that influences
a persons risk perception since there are many ways
in which an individual tends to be overconfident about
their decisions in terms of risk-taking behavior. Within
the behavioral finance literature, overconfidence is one of
the most documented biases according to Daniel and Titman (2000). Confidence can be described as the belief in
oneself and ones abilities with full conviction whereas
overconfidence can be taken a step further in which overconfidence takes this self-reliant behavior to an extreme
(Ricciardi and Simon, 2000a, p. 13). As human beings, we
have an inclination to overestimate our own skills, abilities, and predictions for success. Myers (1989) provided
this viewpoint on the decision making process:
Our use of quick and easy heuristics when forming
judgments and our bias toward seeking confirmation
rather than refutation of our ideas can give rise to the
overconfidence phenomenon, an overestimation of the
accuracy of our current knowledge. (p. 293)
Prospect Theory
The seminal work by Kahneman and Tversky (1979)
advocated a new theory under conditions of risk-taking
behavior and uncertainty known as prospect theory.
Olsen (1997) noted prospect theory gives weight to the
cognitive limitations of human decision makers (p. 63).
Under the assumptions of prospect theory, an investor
departs from the notion of rationality espoused by classical decision theory (the standard finance perspective)
and instead an individual makes decisions on the basis
of bounded rationality advocated by behavioral decision
theory (the behavioral finance viewpoint). Kahneman
and Tverskys prospect theory is based on the notion
that people are loss averse in which they are more
concerned with losses than gains. In effect, an investor
on an individual basis will assign more significance to
avoiding a loss than to achieving a gain.
Investors utilize a compartment in their brains or a type
of mental bookkeeping during the decision-making process. For instance, an investor individualizes each financial decision into a separate account in their mind known
as mental accounting. This investor has an inclination to
focus on a specific reference point (e.g., the purchase price
for a stock or the original stock investment cost) and their
desire is to close each account with a profit (gain) for
that single transaction. Heilar, Lonie, Power, and Sinclair
(2001) described prospect theory from this perspective:
This theory separates the decision choice process into
two stages; in the first stage the menu of available
choices is framed and edited in accordance with the
decision makers prior perceptions; in the second stage
these prospects are evaluated in relation to the decision makers subjective assessment of their likelihood
of occurrence. The prospect with the highest expected
outcome is selected. (p. 11)
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Value
Profit Area:
Assets with profits
are cashed (sold)
too early
Losses
Loss Area:
Assets with losses
are kept (held) for
too long
Gains
Reference Point
99
Loss Aversion
Olsen (2000) noted Early research, using utility-based
models, suggested that investment risk could be measured
by return distribution moments such as variance or skewness (p. 50). In contrast, other researchers explored the
subjective aspects of risk and discovered that individuals
are loss averse. As explained earlier, a central assumption
of prospect theory is the notion of loss aversion in which
people designate more significance to losses than they allocate to gains. The notion of loss aversion is contrary to
the tenets of modern portfolio theory since the discipline
of standard finance makes the assumption that a loss and
gain is equivalent (identical). In other words, according
to basic statistical analysis, a loss is simply a negative
profit and is thus, weighted in the same manner. From an
investment standpoint, during the decision-making process, many investors appear thin-skinned and vulnerable
to losses, and highly determined not to realize a financial
loss. In some instances, investors exhibit a tendency or increased readiness to take risks in the desire of reducing or
avoiding the entire loss (see Figure 10.2).
A main premise of loss aversion is that an individual is
less likely to sell an investment at a loss than to sell an
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Representativeness
Another important heuristic that affects a persons perception of risk is known as representativeness. Behavioral
finance refers to a fundamental mental mechanism that
we set in motion because of abstract rules known as mental shortcuts that are part of the judgment process based
on the work of Tversky and Kahneman (1971). Decision
makers manifesting this heuristic are willing to develop
broad, and sometimes very detailed generalizations about
a person or phenomenon based on only a few attributes
of the person or phenomenon (Busenitz, 1999, p. 330).
Human beings utilize mental shortcuts that make it complicated to analyze new investment information accurately and without bias. Representativeness reflects the
belief that a member of a category (e.g., risky behavior or
hazardous activity) should resemble others in the same
class and that, in effect, should resemble the cause that
produced it. Ricciardi and Simon (2001) provided this perspective:
Representativeness is but one of a number of heuristics
that people use to render complex problems manageable. The concept of representativeness proposes that
humans have an automatic inclination to make judgments based on the similarity of items, or predict future
uncertain events by taking a small portion of data and
drawing a holistic conclusion. (p. 21)
Framing
Another indicator that influences a persons perception of
risk is the format (frame) in which a situation or choice
is presented. A person reveals framing behavior when an
indistinguishable or equivalent depiction of an outcome
or item results in a different final decision or inclination.
Kahneman and Tversky (1979) utilized framing effects
from two significant perspectives within the decision making process: (1) the environment or context of the decision
and (2) the format in which the question is framed or
worded. Essentially, the framing process is an evaluation
of the degree of rationality in making decisions by constructing an examination of whether the equivalent question provided to an individual in two distinct but equal
means will generate the same response. Duchon, Ashmos,
and Dunegan (1991) presented this depiction of framing:
Decision makers evaluate negative and positive outcomes differently. Their response to losses is more extreme than their response to gains which suggests, psychologically, the displeasure of a loss is greater than
the pleasure of gaining the same amount. Thus, decision makers are inclined to take risks in the face of sure
losses, and not take risks in the face of sure gains. (p.
15)
This next framing example is informative for understanding how individuals make decisions in terms of their
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investments. For example, consider the distinctive impressions presented by these two options:
Option A: Would you invest all your money in a new business if you had a 50% chance of succeeding brilliantly?
Option B: Would you invest all your money in a new
business if you had a 50% chance of failing miserably?
According to Weber (1991), The success-frame in A
makes it seem more appealing than the failure-framed
B, although the probability of success versus failure is the
same for both (p. 96). In most instances, people choose
the alternative that seems less risky which is Option A.
The explanation for the selection of Option A was that
this alternative provided the appearance that it is more
psychologically soothing and pleasing instead of Option
B as the best option. Research suggests that this concept
proves that people tend to default to a form of mental
sluggishness. We know we are biased, but we chose not
to correct our heuristic perceptions, according to Ricciardi
and Simon (2001, p. 24). Interestingly, an individual will
consent to the situation as offered and make no attempt
to reformulate it in a comparable and balanced manner
(Piatelli-Palmarini 1994).
Academic researchers have found that small changes in
the wording of judgments can have a prominent effect
on choice behavior. Subtle differences in how risks are
presented can have marked effects on how they are perceived (Slovic, Fischhoff, and Lichtenstein, 1982, p. 483).
Thus, framing effects (that is, the presentation of information) can be utilized to modify an individuals perception
of risk. For instance, Sitkin and Weingart (1995) investigated the association between a framing problem, risk
perception, and risk-taking behavior. The subjects were
63 college students that were provided with a car-racing
scenario (case study) in which the continued sponsorship
of the venture was dependent on the success of winning.
The decision-making process in terms of the case study
was presented with a framing problem based on a potential for a gain or a prospect for a loss. The risk component of
the case study instrument (that is, the car-racing scenario)
was evaluated with specific risk attributes that included
the probability of participation, the significance of opportunity versus the significance of the decision, the potential
loss, the potential gain, whether this judgment was a negative or positive situation, and the likelihood of success.
The findings for the study revealed that (1) situations that
were framed positively were perceived as higher risk than
circumstances that are framed negatively and (2) the extent (degree) to which subjects made risky decisions were
inversely related to their level of given risk perception.
Anchoring
Anchoring is used to explain the strong inclination we all
have to latch on to a belief that may or may not be truthful, and use it as a reference point for upcoming decisions
according to Ricciardi and Simon (2001). The process of
anchoring within the decision-making process is utilized
by an individual to solve intricate problems by selecting
an initial reference point and slowly adjusting to arrive
at a final judgment. For instance, one of the most fre-
101
Familiarity Bias
Familiarity bias has been a subject of inquiry within the
risk perception literature for an array of disciplines from
the social sciences and business administration fields. In
basic terms, people prefer things that are familiar to them.
People root for the local sports teams. Employees like to
own their companys stock. The sports teams and the
company are familiar to them (Nofsinger, 2002, p. 64).
Within the risk domain, familiarity bias is an inclination
or prejudice that alters an individuals perception. When
individuals make assessments of risky behaviors and hazardous activities for studies within cognitive psychology;
the findings have shown people are more comfortable and
tolerant of risk when they are personally familiar with a
specific circumstance or activity. For example, risks that
are familiar are feared less than those that are unfamiliar;
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Gilovich (1981) presented this viewpoint on familiarity, we form associations between existing circumstances
and past situations and are influenced by what we consider to be the implications of these past events (p. 797).
Furthermore, Shefrin (2005) noted the relationship between familiarity bias and representativeness in which
individuals are prone to be excessively optimistic when
they have familiarity with a situation and are able to picture themselves as representative of a successful person in
that situation (p. 46).
Since 1975, the psychology of familiarity has been a popular area of investigation within the behavioral accounting risk perception literature. In particular, familiarity bias
was the main behavioral risk characteristic (indicator) in
which behavioral accounting risk perception researchers
explored for 12 research studies during the time period
of 1975 to 2002 (see Ricciardi (2004)). Within the behavioral finance literature, familiarity bias has been applied
in several areas of financial and investment decision making: (1) International finance and asset allocation in which
investors have demonstrated a preference for investing in
domestic stocks (familiar assets) rather than international
stocks (unfamiliar assets); (2) Employees that have invested most of their retirement savings in their companys
stock (familiar assets); and (3) Portfolio managers have
demonstrated a tendency to invest money in local companies or stocks with recognizable brand names or reputations. The risk perception literature review by Ricciardi
(2004) revealed the notion of familiarity was addressed or
alluded to in a number of research endeavors in behavioral finance. Baker and Nofsinger (2002) provided this
description of familiarity bias from a behavioral finance
point of view:
People often prefer things that have some familiarity
to them. Consequently, investors tend to put too much
faith in familiar stocks. Because those stocks are familiar, investors tend to believe that they are less risky
than other companies or even safer than a diversified
portfolio. (p. 101)
clist, motorcycle and environment is flawless, perfect control can be achieved. Control is the ability to foresee and
navigate potential hazards, thus erasing risk in a material
way (p. 71). Strong (2006) presented this portrayal of the
psychology of control within a gambling environment:
Casinos are one of the great laboratories of human behavior. At the craps table, it is observable that when the
dice shooter needs to throw a high number, he gives
them a good, hard pitch to the end of the table. A low
number, however, demands a nice gentle toss. Realistically, the force of the throw has nothing to do with
the outcome of a random event like the throw of dice.
Psychologists refer to this behavior as illusion of control.
We like to pretend we are influencing the outcome by
our method of throwing the dice. If you force the issue,
even a seasoned gambler will probably admit that the
dice outcome is random. (pp. 273274)
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Loewenstein, Hsee, Weber, and Welsh (2001) noted several valuable points associated with risk and affect. The
emotional aspect of risk frequently departs from the cognitive influences of risk perceptions. For decisions under
risk and uncertainty, affective responses (emotional consequences) commonly apply primary reactions to behavior above cognitive influences and cause behaviors that
are not adaptive. Furthermore, affective reactions result
in behavioral outcomes that diverge from what people
considered the optimum outcome of a decision.
The cognitive factors that are mentioned involve how an
individual processes information and what factors influences their perception of risk for a certain decision (e.g.,
issues of heuristics, framing, anchoring, representative-
ness). In essence, to fully understand the judgmental process of investors, researchers must consider both the cognitive and affective (emotional) aspects of how investors
process information and perceive risk for a given activity,
situation or circumstance.
Sjoberg
[2004]; Schnur, DiLorenzo, Montgomery, Erblich,
Winkel, Hall, and Bovbjerg [2006]; and Peters, Slovic,
Hibbard, and Tusler [2006].) During the 1970s, the original risk perception studies in psychology by researchers
at the Decision Research organization alluded to a negative feeling of concern (worry) about risk known as dread
or dreadness that influences a persons perception of risk
towards a specific risky behavior or hazardous activity.
In relation to the emotional aspects of risk, the process of
worrying is a lasting concern with a past or an upcoming
event. Worry is a category of risk assessment that makes
a person feel as if he or she were reliving a past occasion
or living out a future one, and the individual cannot stop
these types of contemplations from happening.
A behavioral definition of worry is how a person might
react towards a specific situation or decision that causes
anxiety, fear, or unhappiness. MacGregor (1991) offered
this overview of worry from a cognitive perspective:
One way to think about worry is a cognitive process
that occurs when we are uncertain about a future event
or activity. In common usage, worry is often used synonymously with terms like fear and anxiety. However, in a strict sense, worry is a primarily a mental activity, whereas anxiety and fear include emotional components and associated physical responses . . . Worry is
thinking about uncertainties, whereas anxiety includes
the gut-level feeling that accompanies uncertainty.
(p. 316)
Researchers in the area of risk perception from the social science literature have debated over whether worry
(or the act of worrying) is a cognitive or affective (emotional) process. MacGregor (1991) considered worry from
reaction, Sjoberg
(1998) recognized the problems in identifying the differences between emotional and cognitive
concepts. Loewenstein, Hsee, Weber, and Welsh (2001)
provided this perspective:
The risk-as-feelings hypothesis . . . postulates that responses to risky situations (including decision making) result in part from direct (i.e., not cortically mediated) emotional influences, including feelings such
as worry, fear, dread, or anxiety. People are assumed
to evaluate risky alternatives at a cognitive level, as
in traditional models, based largely on the probability and desirability of associated consequences. Such
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SUMMARY
This chapter provided a general discussion of the topics of
perceived risk and perception. Risk perception (perceived
risk) involves the subjective judgments that people utilize
in terms of their evaluation of risk and the degree of uncertainty. The practice of perception is a technique by which
people categorize and understand their sensory intuitions
in order to provide an assessment of their surroundings
with the recognition of actions or objects rather than
simply factors or traits.
A considerable number of research studies on perceived
risk and risk-taking behavior by social scientists have
crossed over and are now applied in various business settings. The current risk perception research in behavioral
finance, accounting, and economics were first started during the ground breaking studies on risky behaviors and
hazardous activities at the Decision Research organization. Their influential research in perceived risk, as well as
that by other social scientists, revealed:
r Perceived risk is quantifiable, foreseeable, subjective
105
r
r
r
r
ACKNOWLEDGMENTS
The author would like to thank the following individuals for their support and inspiration: Robert Olsen, Hugh
Schwartz, Hersh Shefrin, Meir Statman, Terrance Odean,
Paul Slovic, Bernd Rohrmann, Igor Tomic, Michael Jensen,
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